Following the announcement of Libra and with the start of Christine Lagarde’s presidency, the ECB’s efforts in the area of “central bank digital currencies” (CBDCs) have intensified noticeably. The basic idea behind CBDC is ultimately the transfer of physical cash into the digital world. However, the exact design of a CBDC system is crucial concerning the impact on the banking and financial sector, social acceptance and the monetary policy options of the central bank. In the last two months, the ECB has published concrete CBDC concepts. Although these are not final, they do provide a good indication of where the journey in the euro area could lead. We outline this possible CBDC world in this study. Apparently, banks could play a central role in the crypto euro world and should, therefore, prepare themselves technologically.
In response to the emergence of Bitcoin and other cryptocurrency projects, the first central banks began to analyse a possible introduction of their own digital currency as early as 2014. The announcement of Libra in the summer of 2019 (for more details on Libra see Groß, Herz, Schiller, 2019, link here) has further accelerated this process, with more and more central banks now considering the introduction of their own central bank digital currency (CBDC). According to the Bank for International Settlements (BIS), 70% of the world’s central banks are currently investigating the implications of introducing a CBDC — 10% of the world’s central banks even expect to introduce a CBDC in the short term (1–3 years), and as much as 20% in the medium term (up to 6 years) (see Boar, Holden, Wadsworth, 2020).
Since 2017, the Swedish central bank (Riksbank) has been analysing the introduction of its own digital central bank currency to strengthen the role of central bank money in the context of a sharp decline in cash demand and thus reduce the dependence on digital bank money (bank deposits). The Swedish central bankers argue that — in a world without CBDC — turbulences in the financial sector could have a more negative impact on their economy.
The Chinese central bank (PBoC) announced in autumn 2019 that it would introduce its own CBDC soon to reduce its dependence on the financial sector and to be able to offer digital transactions in central bank money. Presumably, the aim is also to monitor citizens’ financial transactions even more closely and to “pool” them at the central bank. Besides, other smaller central banks (in Cambodia or the Marshall Islands) have also announced the issuance of a CBDC soon. The direction is clear: more and more central banks are looking into the introduction of their own digital central bank currency. 2020 could, therefore, be the year in which the first CBDC is launched.
A third form of central bank money
CBDC is, simply put, digitised cash. The ECB defines CBDC as “a liability to a central bank that is made available to individual citizens in digital form” (ECB, 2019). CBDCs would thus represent a third form of central bank money, alongside banks’ reserves at the central bank and physical cash. In addition, a CBDC can generally be classified according to the following design features:
- Interest payment: A CBDC can be either interest-bearing or non-interest-bearing. A non interest-bearing CBDC would not yield interest and would be similar to physical cash. Negative interest rates are also possible.
- Access: Access to CBDC can be restricted to certain actors in an economy, such as banks or other financial institutions. In this case, the CBDC is called “wholesale CBDC”. A CBDC that is available to the general public is called “retail CBDC”.
- Operational set-up: A CBDC can be either account-based or value-based. In the case of account-based CBDC, customers keep their funds in an account with the central bank. In the case of a value-based CBDC (also called token-based CBDC), the CBDC would be issued directly to the real economy as a token, similar to physical cash.
- Technology: A CBDC can be issued via a distributed database (Distributed Ledger Technology, DLT) or a conventional centralized database. Issuance via a DLT would also lead to the CBDC being made more programmable and to the use of euro-denominated smart contracts.
Along with Lagarde came the CBDC task force
The ECB has intensified its efforts around CBDC. At her first press conference as President of the ECB in November 2019, Christine Lagarde announced that she would initiate a separate internal task force and further develop analyses on CBDC. More specifically, she made the following comments on CBDCs: “My personal conviction is that given the developments we are seeing […] in the stable coins projects, […] we better be ahead of the curve if that happens. Because there is clearly a demand out there that we have to respond to.”
Following these announcements, in December 2019 the ECB published a paper on a concrete CBDC prototype based on a DLT, which is intended to allow partially anonymous payments (ECB, 2019). Just one month later, another working paper followed, proposing a CBDC system to prevent large outflows from the financial sector (disintermediation) to ensure financial stability (Bindseil, 2020). As with other central banks, the ECB’s motives behind a CBDC introduction are complex. These range from the provision of “programmable money” (which can be used in IoT applications), to improving the efficiency of cross-border payments (which would require compatibility between the respective CBDCs), to monetary policy and financial stability considerations (overcoming the effective zero lower bound and reducing the dominance of bank money). However, before discussing the last point in more detail, it is worthwhile to present the ECB’s plans briefly.
CBDC à la ECB — Some anonymity
Today, common payment methods, such as bank transfers, payments via ApplePay or PayPal or cash transactions, differ in their data security / anonymity. For example, if a transaction is processed via Apple’s payment service ApplePay, the transaction data is visible to Apple. In case of a bank transfer, the processing banks can view the payment details. However, there has been a completely anonymous payment method for centuries: cash. Cash transactions are carried out without the involvement of an intermediary, so the transaction details are only available to the two transaction partners. The level of data security and anonymity is also of great importance in the context of CBDC.
In the publication published in December 2019, the ECB presented a concrete retail CBDC prototype which — similar to cash — (partially) guarantees anonymous payments while at the same time takes into account anti-money laundering (AML) regulations. It is noteworthy that the proposed CBDC prototype is based on a DLT and uses the Corda framework (with Corda, all participants in the network can interact with each other and record and manage agreements with each other). The ECB only issues the CBDC here; a decentralised network of intermediaries such as banks takes over the “heavy lifting” by requesting AML checks, providing the necessary applications and storing the cryptographic keys for initiating payments in their own wallets.
Figure 1: Two-tiered system: division of labour between the ECB and banks
In the proposed system, the identity and transaction history of a user are therefore in principle not disclosed to the central bank and some transactions (although limited in amount) can be carried out without the AML authority’s knowledge.
Technically, this (partial) anonymity is implemented by not transmitting the identity of the user to the AML authority when so-called anonymity vouchers are attached to a transaction. These vouchers are issued by an AML authority at regular intervals, are valid for a certain period of time and allow anonymous transfers of funds for a limited CBDC amount over a pre-defined period of time. Each citizen is endowed with a certain number of anonymity vouchers. Once all vouchers have been redeemed, transactions are no longer processed anonymously.
However, it should be noted that the transactions are not entirely anonymous. The banks involved have insight into the transactions, which is why such a CBDC system would have a much lower degree of anonymity than cash. Completely anonymous transactions could theoretically be technically implemented in DLT systems. There are also already initial test trials (including so-called zero-knowledge proofs), but these could take several years before they are market-ready in Corda.
How does a 100 euro transaction in this system work in practice?
- The customer requests 100 euros in CBDC from the bank (exchange rate: 1 to 1).
- The bank checks whether the CBDC account balance is above a certain limit after the transaction.
- If 2 is fulfilled, the bank will request 100 CBDC units from the central bank on behalf of the customer.
- The central bank debits the bank’s reserve account with EUR 100 and authorises the creation of new CBDC units by confirming the transaction.
- The 100 CBDC units are credited to the customer’s CBDC account at the bank and the customer’s current account is debited by 100 euros.
If 100 anonymity vouchers are attached to the transaction, the central bank and the AML authority have no insight into the identity and transaction history of the customer. If the customer does not wish or is unable to attach anonymity vouchers, the authority has access to the transaction.
Theoretically, a CBDC system could be conceivable in which the central bank issues CBDCs directly — i.e. without banks — to customers. However, this would entail complex operational tasks for the central bank. In order to avoid this, the ECB has outlined a system in which CBDCs are issued to households via banks (two-tiered approach). Thus, banks would be important intermediaries and, as with traditional bank transfers, would be responsible for ensuring the accuracy of transactions and responding to customer demand for CBDCs in a similar way to demand for cash today.
CBDC à la ECB — Finding the balance
A digital form of cash, which offers similar conveniences to a traditional bank account, automatically competes with deposits. For the individual saver, CBDCs offer a decisive advantage: the money saved is central bank money and not bank money, i.e. a central bank fully guarantees the safety of the money. Especially in times of financial crises, this additional safety is likely to play a major role for customers, since there will always be residual doubts about the stability of the banking system. This could have two consequences: Firstly, households and firms could reduce their deposits with banks in favour of CBDCs and, secondly, in times of financial uncertainty, they could withdraw deposits from banks on a larger scale and park them “safely” at the central bank.
In the literature, the first effect is called disintermediation. Ultimately, the central bank’s balance sheet is extended while the balance sheets of commercial banks contract. Besides a supposed stabilisation of the financial sector, this would have negative consequences. Banks could also decrease their lending because of the decline in deposits. It is highly unlikely that the central bank itself would enter the credit business, as it lacks the expertise and the necessary risk appetite compared to the banking sector. This could lead to a shortage and misallocation of credit. In addition, banks would come under pressure, as with fewer deposits, they would miss out on a cheap source of financing. Possible additional costs are likely to be passed on to borrowers and could lead to a slowdown in lending.
The second effect is known as a bank run. Disturbances in the financial sector, such as the threat of bank failure, would encourage actors to convert their deposits from risky bank money into central bank money as quickly as possible. Such behaviour would lead to additional liquidity being withdrawn from the already troubled banks, making insolvency more likely. Although bank runs could of course occur without CBDC, they are likely to be more severe with digital central bank money: investors can easily exchange their money from home and do not have to worry about the safety of their money, as the amount is simply moved digitally from one account to another.
CBDCs can, therefore, have broad implications for the structure, stability and efficiency of the financial sector. In the design of CBDC it is therefore crucial to realise efficiency-enhancing effects for payments — such as lower transaction fees and faster transactions — while at the same time minimizing disintermediation effects. To achieve this goal, various approaches are currently being discussed. Ulrich Bindseil, the ECB’s Director General for Market Infrastructures and Payments, proposes to offer CBDC in two different tiers with different interest rates. Investors could then only hold CBDCs up to a certain maximum amount in tier 1. All funds beyond this threshold would automatically be assigned to tier 2, in which investors would have to accept a significantly lower interest rate. CBDC would thus remain attractive as a means of payment, but would not be suitable as a store of value. In concrete terms, this means that households can park only part of their money (with at least 0% interest rate) at the central bank. This amount would be just as much as is normally required for payment transactions. Bindseil’s estimation of this limit is roughly 3,000 €. Anything beyond that would be remunerated at a significantly lower interest rate, which would then be negative in times of money market interest rates at or near zero.
The possible ECB-CBDC world: Two-tiered — twice!
The ECB’s concepts presented are by no means final, but nevertheless provide a good indication of where the journey in the euro area could lead. In summary, the following points become apparent:
- The ECB seeks to allow — in contrast to the PBoC, for example — at least a certain amount of anonymity and privacy for payments with CBDC. Currently, however, the differences vis-à-vis cash would still be tremendous. Payments would not be possible in the current proof of concept without the knowledge of the banks involved, but anonymity could theoretically be technically implemented in the future.
- The ECB is keeping a close eye on the implications of a CBDC introduction for banks. The considerations of a two-tier CBDC system, with potentially very negative interest rates for those CBDCs that are not used as payment instruments but as store of value, show that the ECB does not wish to cause large-scale deposit withdrawals from the financial sector. However, a certain shift from bank to central bank money still seems likely.
- A two-tier system could also arise between the ECB and the commercial banks. For example, the central bank does not appear to be very keen on handling payment processing with CBDCs itself and storing the cryptographic keys for households. In the future, banks could take over or have to take over these tasks (if it became necessary for regulatory reasons). This gives the crypto custody licence introduced in Germany at the beginning of this year an additional significance. Since, in the end, this licence could be necessary not only for the custody of Bitcoin and Co. but also for the custody of CBDCs. The software solutions that have been available in the Bitcoin world for years, for example for wallets or custody solutions (keyword “cold storage”, i.e. the storage of cryptographic keys protected from remote access), could ultimately be used not only for the secure storage and sending and receiving of Bitcoins for customers, but also for CBDCs.
- The CBDC ambitions of central banks are also likely to have monetary policy motives. According to the motto: once physical cash (interest rate: 0%) has largely been replaced by digital cash, any negative interest rate can be set for digital cash without giving customers an option to “escape” these negative interest rates. In this regard, the introduction of CDBC could be a first step. Despite all the technical difficulties, this step is likely to be much less controversial than a ban on physical cash. However, central banks would have to make other store of values — such as gold or Bitcoin — correspondingly unattractive as well. The current ECB publications also do not suggest that drastic negative interest rates are imminent in the event of a CBDC introduction. But, when it comes to monetary policy, we know by now: “Never say never!”
Bindseil, U. (2020): Tiered CBDC and the financial system, Working Paper Series, №2351.
Boar, C., Holden, H., Wadsworth, A. (2020): Impending arrival — a sequel to the survey on central bank digital currency, BIS Paper №107.
EZB (2019): Exploring anonymity in central bank digital currencies, IN FOCUS, №4.
Groß, J., Herz, B., Schiller, J. (2019): Libra — Concept and Policy Implications, University of Bayreuth Working Paper Series, №02–19.
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